Friday, August 24, 2012

Tax Increase Expectations Depress The Economy Much More Than Government Spending Cuts; Anticipated Tax Increases Decrease Private Investment Unlike Spending Cuts: Government Spending Cuts Raise Business Confidence: Tax Increases Likely To Create Deep Recessions

From "The output effect of fiscal consolidations" by Alberto Alesina, Carlo Favero and Francesco Giavazzi, August 2012, [HT: Greg Mankiw]:
Do sharp reductions of deficits and government debts (labeled "fiscal adjustments") cause large output losses? This question is at the forefront of the policy debate, given that many OECD countries sooner or later will have to reduce their public debts. The answer which this paper provides is that it matters crucially how the consolidation occurs. Fiscal adjustments based upon spending cuts are much less costly in terms of output losses than taxbased ones. In particular, spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Instead, tax-based adjustments have been followed but prolonged and deep recessions. The difference is remarkable in its size and cannot be explained by different monetary policies during the two type of adjustments.
We find that the heterogeneity in the effects of the two types of fiscal adjustment (tax-based and spending-based) is mainly due to the response of private investment, rather than that to consumption growth. Interestingly, the responses of business and consumers’ confidence to different types of fiscal adjustment show the same asymmetry as investment and consumption: business confidence (unlike consumer confidence) picks up immediately after expenditure-based adjustments.
we study the response of output (and of the other variables of interest) to multi-period fiscal consolidation plans –that is sequences of tax increases and spending cuts, announced in some year and then implemented or revised in subsequent years.
although slightly different across countries–yield a strong common message: tax-based plans induce prolonged and deep recessions, while spending-based plans are associated with very mild and short-lived recessions, in some cases with no recession at all.
The study looked at announcements of government plans to cut spending and raise taxes, similar to those proposed by Obama and future tax increases similar to those included in Obama's health care law.

The paper is consistent with other high quality research in this area, including research by Obama's adviser Chrisitne Romer, former Chair of the Council of Economic Advisers in the Obama administration. See her recent paper: Romer C. and D. H. Romer (2010), “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks”, American Economic Review, 100(3), 763—801. Her paper found that public announcements of proposed tax increases in the Congressional Record and newspapers had a negative effect on economic output prior to their legislative enactment.

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